Order Code RS22214
July 29, 2005
CRS Report for Congress
Received through the CRS Web
Cash Balance Pension Plans:
Selected Legal Issues
Erika Lunder
Legislative Attorney
American Law Division
Jennifer Staman
Law Clerk
American Law Division
Summary
Over the past few years, cash balance pension plans have received significant
attention. In particular, three issues have been controversial: the negative effect of a
plan conversion on older employees due to wear-away, the whipsaw effect that may
occur when computing a lump-sum payment of benefits prior to normal retirement age,
and the claim that these plans violate federal laws prohibiting age discrimination. This
report discusses the wear-away and whipsaw issues, a proposal by the Treasury
Department that addresses them, and relevant legislation introduced in the 109th
Congress (H.R. 2830 and S. 1304). For information on the age discrimination issue, see
CRS Report RL33004, Cash Balance Pension Plans and Claims of Age Discrimination.
Federal laws, including the Employee Retirement Income Security Act (ERISA) and
the Internal Revenue Code (IRC), distinguish between two types of pension plans: defined
benefit plans and defined contribution plans.1 In a defined benefit plan, an employee is
promised a future benefit that is traditionally expressed as an annuity beginning at normal
retirement age. The annuity is typically determined by a formula that factors in the
employee’s years of service and the average salary of his or her highest salaried years. In
a defined contribution plan, the employee is promised that the employer will currently
make a specified contribution to the employee’s pension account. The contribution is
generally a percentage of the employee’s salary.
A cash balance plan is a hybrid pension plan in that it is a defined benefit plan that
looks like a defined contribution plan because the employee’s promised future benefits
are stated as his or her account balance.1 The account is hypothetical (i.e., each employee
does not actually have an account), but is used to conceptualize the amount of benefits the
1 For more information, see CRS Report RL30196, Pension Issues: Cash-Balance Plans, by
Patrick Purcell.
Congressional Research Service ˜ The Library of Congress

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employee has accrued. The account reflects contributions equaling a percentage of salary
(called pay credits) and interest earned on those contributions (called interest credits).
An employer may choose to adopt a cash balance plan as a new retirement plan or
may convert its traditional defined benefit plan to a cash balance plan. During the past
two decades, numerous employers have converted or considered converting their plans.
A conversion is subject to the rules that apply to any plan amendment, including the anti-
cutback rule. Under that rule, an amendment may not (1) decrease an accrued benefit or
(2) eliminate or reduce an early retirement benefit or retirement-type subsidy with regard
to service that has already been performed, except in limited circumstances and with prior
approval by the Treasury Secretary.2 The plan amendment may reduce future benefit
accruals since these benefits have not yet been earned. This reduction may include
ceasing benefit accrual for a period of time. Any amendment that significantly reduces
the rate of future benefit accrual requires clearly-written notice to affected participants.3
Wear-away
In a conversion from a defined benefit plan to a cash balance plan, an employee’s
accrued benefit may be converted to a hypothetical opening account balance. If this
opening account balance is lower than the present value of the benefits the employee has
already accrued, then he or she may experience a period of wear-away.4 Wear-away
occurs during the time it takes the account balance under the cash balance plan to surpass
the accrued benefit the employee has already earned under the defined benefit plan.
During this period, an employer may not be required to make new contributions to an
employee’s cash balance plan account until the account balance catches up to the
previously accrued benefit. Because of wear-away, an employee may have to work
several years before accruing any additional pension wealth under the cash balance plan.5
There can be wear-away of normal retirement benefits and/or early retirement
benefits and retirement-type subsidies. Wear-away of normal retirement benefits occurs
when the opening account balance in the cash balance plan is less than the present value
of the employee’s accrued benefits expressed as a pension benefit beginning at normal
retirement age. Wear-away of early retirement benefits and subsidies occurs when the
opening account balance is less than the present value of the employee’s accrued benefits
2 ERISA § 204(g); ERISA § 302(c)(8); IRC § 411(d)(6); IRC § 412(c)(8).
3 ERISA § 204(h)(1).
4 There are several situations in which the opening account balance may be less than the accrued
benefits under the old plan. For example, if the opening balance represents the lump sum
distribution of the employee’s accrued benefits under the old plan, the IRS requires that the
defined benefit lump sum be calculated using the interest rate for 30-year Treasury bonds. This
interest rate may be lower than the plan funding rate, which can translate into a cash balance plan
account balance that is less than the employee’s accrued benefit under the old plan. Furthermore,
an employer is not required to calculate an opening account balance in a cash balance plan based
on an employee’s previously accrued benefit under the old plan. The opening account balance
can be zero if an employer so chooses, in which case the employee receives the accrued benefits
under the old plan and the benefits accrued under the cash balance plan.
5 See generally E.A. Zelinsky, The Cash Balance Controversy, 19 Va.Tax Rev. 683, 702-03
(2000).

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expressed as a pension benefit that reflects the early retirement benefits and subsidies.
Thus, while the anti-cutback rules prohibit an employee from losing an early retirement
benefit or subsidy attributable to service before the amendment, the expected early
retirement benefits or subsidies offered under a traditional defined benefit plan may be
worn away in the same manner as normal retirement benefits.
Critics have argued that the wear-away concept violates the anti-cutback rules of
ERISA. In one of the few cases to examine cash balance plans and the concept of wear-
away, Campbell v. BankBoston, the First Circuit Court of Appeals held that the
occurrence of wear-away due to a conversion from a defined benefit plan to a cash
balance plan did not violate the anti-cutback rules.6 In this case, BankBoston converted
its defined benefit plan to a cash balance plan. The cash balance plan contained a benefit
safeguard provision which ensured that long-term employees would receive the greater
of the cash balance plan amount or the amount that would have been received under the
defined benefit plan. Several years later, BankBoston amended the cash balance plan and
removed the benefit safeguard provision. Employees then maintained opening account
balances based on the present value of their accrued benefits at the time of the
amendment. If an employee had accrued a greater benefit under the old defined benefit
plan than the amount of the opening account balance, an employee’s pension entitlement
would not grow until the account balance surpassed the previously accrued benefit.7
Campbell, a long-term employee of BankBoston, earned no new benefit amount
between the time of plan conversion and his retirement. Campbell claimed that this
ceasing of benefit growth due to the plan conversion amounted to a forfeiture in violation
of ERISA’s anti-cutback rules. The Court of Appeals disagreed, holding that the anti-
cutback rules protected Campbell’s accrued benefits, but not Campbell’s future expected
benefits.8 Under ERISA, BankBoston had the ability to amend or terminate future
accruals, so long as Campbell received the pension benefits previously accrued.9
Finally, while this report does not address the age discrimination claims, it should
be noted that critics have also argued that the wear-away concept is inherently age
discriminatory because it is more likely for older workers to have higher opening account
balances than younger workers. It does not appear that any court has accepted this
argument. For more information, see CRS Report RL33004, Cash Balance Pension Plans
and Claims of Age Discrimination
, by Erika Lunder and Jennifer Staman, at pages 6-15.
Whipsaw
In general, cash balance plans are designed so that employees who leave employment
prior to normal retirement age may receive a lump-sum payment of their accrued benefits
at the time of termination, as opposed to waiting until normal retirement age. Depending
on how the value of the lump-sum payment is determined, there may arise what is known
as the whipsaw effect. The basic issue is whether the lump-sum payment equals the
6 Campbell v. BankBoston, 327 F.3d 1 (1st Cir. 2003).
7 See generally Zelinsky, 19 Va. Tax Rev. at 703.
8 Id. at 19.
9 Id. at 18-19.

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current account balance or the present value of the accrued benefits expressed as an
annuity beginning at normal retirement age.
Some employees have argued that the lump-sum payment must equal the present
value of the accrued benefit expressed as an annuity beginning at normal retirement age.
This is based on the argument that ERISA and the IRC require that a lump-sum payment
of an accrued benefit in a defined benefit plan be the actuarial equivalent of that benefit,
determined according to statutorily-prescribed interest rate and mortality assumptions.10
Under this argument, the employee’s lump-sum payment in a cash balance plan must be
calculated by (1) projecting the hypothetical account balance to normal retirement age by
adding future interest credits, at the interest rate specified in the plan, to the account, (2)
converting the balance to an annuity payable at that age, and (3) determining the present
value of that annuity using the statutorily-prescribed interest and mortality assumptions.
The lump-sum distribution is then the present value of the annuity. In 1996, the IRS
released proposed guidance on how to compute the lump-sum payment under a cash
balance plan and used this method.11
The whipsaw effect arises if the interest rate used to project the account balance to
normal retirement age [the “projection rate”] is higher than the interest rate used to
determine the present value of the annuity beginning at normal retirement age [the
“discount rate”]. In such a situation, the value of the lump-sum payment (i.e., the present
value of the annuity) will be greater than the employee’s account balance. This result will
be common if it is required that the projection rate be the rate specified in the plan for the
interest credits. This is because many plans use an interest rate for the interest credit that
is higher the statutorily-prescribed discount rate.
Some employers have argued that since the benefits of a cash balance plan are
expressed as the employee’s hypothetical account balance, the amount in the account
should be distributed as a lump-sum payment. In other words, they claim the lump-sum
distribution does not have to include the present value of the post-termination interest
credits. Some of these employers have argued that the method outlined in the IRS
proposed guidance is incorrect. Others have followed that method, but used the
statutorily-prescribed discount rate as both the projection rate and the discount rate. This
method results in the value of the lump-sum payment equaling the current value of the
employee’s hypothetical cash balance account.
Three U.S. courts of appeals have held that plans must follow the procedure in the
IRS proposed guidance and use the plan’s interest rate as the projection rate.12 For
example, in Berger v. Xerox Corp. Retirement Income Guarantee Plan, the U.S. Court
of Appeals for the Seventh Circuit rejected the company’s arguments that the value of a
lump-sum payment could equal the hypothetical account balance on the date of
distribution. In the Xerox plan, the interest credit was the average one-year Treasury bill
10 ERISA § 203(e); IRC §§ 411(a) and 417(e).
11 IRS Notice 96-8 (Feb. 5, 1996).
12 Berger v. Xerox Corp. Retirement Income Guarantee Plan, 338 F.3d 755 (7th Cir. 2003);
Esden v. Bank of Boston, 229 F.3d 154 (2d Cir. 2000); Lyons v. Georgia-Pacific Salaried
Employees Retirement Plan, 221 F.3d 1235 (11th Cir. 2000).

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rate for the prior year plus 1%. In determining the value of a terminating employee’s
lump-sum payment, the plan used the statutorily-prescribed rate as both the projection rate
and the discount rate.13 Employees who terminated employment and chose to receive a
lump-sum distribution of their accrued benefits prior to reaching normal retirement age
received the amount in their cash balance accounts as of the date of distribution. Former
employees sued, alleging that the plan’s method of using the same rate as both the
projection and discount rates violated ERISA.
The court held that the plan had to use the rate specified in the plan for the interest
credits as the projection rate. It rejected Xerox’s argument that the employees’
entitlement to future interest credits terminated when they chose to take a lump sum
distribution and, therefore, they were only entitled to the account balance on the date of
distribution. Instead, the court reasoned that since a terminating employee was entitled
to an annuity beginning at normal retirement age which included the interest credits, an
employee who chose to take his or her accrued benefits prior to reaching normal
retirement age had to receive a distribution that was actuarially-equivalent to that
annuity.14 Thus, a lump-sum payment had to include the present value of those credits.
The court also stated that the IRS notice that prescribed a procedure that reached this
result was “an authoritative interpretation of the applicable statutes and regulations.”15
The court went on to note that if the company believed its argument that the employees
were only entitled to their account balances, “it would not go through the motions of first
projecting future credits at the [statutorily-prescribed] rate and then discounting them at
the same rate to present value . . . .”16 The court further stated that because the company’s
method meant that employees who chose the immediate distribution gave up their right
to an annuity at normal retirement age that included the interest credits, the employees
were basically “being invited to sell their pension entitlement back to the company cheap,
and that is a sale that ERISA prohibits.”17
Treasury Department’s Proposal
In 2004, the Treasury Department announced a legislative proposal that would
address the wear-away and whipsaw issues.18 First, it would prohibit the wear-away of
normal and early retirement benefits. A plan that violated this would be subject to a
13 As the court noted, because both the interest rates would vary, it is not clear that this method
would always result in the whipsaw effect.
14 Berger, 338 F.3d at 761.
15 Id. at 762.
16 Id. at 761.
17 Id. at 762.
18 Treasury Department Press Release JS-1132 (Feb. 2, 2004), which is available at
[http://www.treas.gov/press/releases/js1132.htm]. The proposal would also create a new age
discrimination test for cash balance plans and require, for the first five years after a conversion,
the benefits earned under the cash balance plan be no less than the benefits that would have been
earned under the old plan. In addition to the proposal, the Treasury Department has taken other
actions with respect to the cash balance issue, including proposing and then withdrawing
regulations. For more information, see CRS Report RL33004, Cash Balance Plans and Claims
of Age Discrimination.


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penalty tax that equals 100% of the difference between the benefits required under the
proposal and the benefits actually provided, limited to the greater of the plan’s surplus
assets at the conversion or the plan sponsor’s taxable income. There would be no penalty
if participants were given a choice between the two plans or if current participants were
grandfathered under the old plan’s formula. Second, the proposal would end whipsaw.
Under the proposal, the lump-sum distribution of an employee’s benefit prior to reaching
normal retirement age could equal the amount in the employee’s hypothetical account, so
long as the plan did not credit interest at an above-market level. The proposal would
apply prospectively and would not be intended to create an inference as to the status of
cash balance plans or conversions under current law. It has been included in the revenue
provisions of the Administration’s budget proposals for fiscal years 2005 and 2006.19
Legislation Introduced in the 109th Congress
H.R. 2830. In June of 2005, Congressmen John Boehner, Sam Johnson, and Bill
Thomas introduced H.R. 2830, the Pension Protection Act of 2005, to update several areas
of pension law.20 One of the ways that the act could affect the legal issues discussed in this
report is through new requirements for calculating lump-sum distributions. As discussed,
under current law, a defined benefit plan is generally required to provide employees’
accrued benefits in the form of an annuity, but can offer to provide these benefits as a lump
sum amount that is actuarially-equivalent to that annuity. The act would change the
interest rate that is used in calculating this lump sum amount, from a 30-year Treasury rate
to varying interest rates as provided under the funding rules of ERISA and the IRC. These
interest rates would reflect the yields on investment grade corporate bonds and increase
or decrease based upon the number of years existing before an annuity could be paid out.
S. 1304. The Pension Benefits Protection Act of 2005 would impose requirements
on any employer whose conversion to a cash balance plan had the effect of reducing the
rate of future benefit accrual for at least one participant. The act would require that the
employer allow employees who are at least 40 years old or have at least 10 years of service
under the plan the option at retirement of receiving benefits under the traditional or cash
balance plan. The employer would also be required to provide these employees with a
comparison of their present and projected accrued benefits under both plans. Additionally,
the act would include a provision to prohibit wear-away of both normal and early
retirement benefits in plans with at least 100 participants. The act would apply to all
converted plans, unless the IRS had approved the conversion before June 24, 2005. Plans
that had converted prior to or within 90 days of the act’s enactment would have 90 days
after the act’s enactment to comply with the new requirements.
19 The proposal for FY2006, found in the General Explanations of the Administration’s Fiscal
Y e a r 2 0 0 6 R e v e n u e P r o p o s a l s
o n p a g e s 8 1 - 8 4 , i s a v a i l a b l e a t
[http://www.treas.gov/offices/tax-policy/library/bluebk05.pdf].
20 For a general discussion of the act, see CRS Report RS22179, H.R. 2830: The Pension
Protection Act of 2005
, by Patrick Purcell. A companion bill, H.R. 2831, was also introduced.
This bill amends the age discrimination provisions of ERISA and the IRC and establishes a
standard for testing whether cash balance plans are age discriminatory.